Assume you have just been hired as a business manager of PizzaPalace, a regional

Question

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

Percent Financed with Debt, wd rd
0%

20 8%

30 8.5

40 10

50 12

A. Now, to develop an example that can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000.
(1) Construct partial income statements, which start with EBIT, for the two firms.

(2) Now calculate ROE for both firms.

B. With the preceding points in mind, now consider the optimal capital structure for PizzaPalace.

(1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.
(2) Now calculate the corporate value for each capital structure.

C. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace’s optimal capital structure?

Explanation / Answer

1) Ans:- Partial Incomes statements of the two companies Firm U and Firm L in that Firm U does not have any Debt and Firm L have 12% Debt on $10000, And Assets$20,000 for the both the Firm,

Tax Rate is 40%on Firms Assets,

Earnings before interest and Taxes expected $3000.

Firm U Firm L

Assets $20,000 $ 20,000

Equity $20,000 $10,000

EBIT Same for the both the firms.

Intrest 0 1,200

EBT $3,000 $1,800

Taxes 1,200 720

NI $1,800 $ 1,800

2) Ans:- Calculating ROE for the firms.

ROE=Net income ÷ shareholders’ equity

ROE for Firm U =9.0 %

ROE for Firm L =10.8 %

B 1)Ans:-   

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

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